April ’14 Newsletter: Is the Recovery Sustainable?

Recovery has started, according to some data. Is it sustainable? Or is it based on asset prices inflated by easy monetary policies? Inside this newsletter:
* Bond markets and the real economy * Central Banking – The Illusion of Tapering * The Return of Bubbles?

Summary

Troubled countries are facing favourable conditions on the credit market. Does this prove that the recovery is healthy or that the recovery rests on fragile foundations?

Most economists continue to hail a European economic recovery: business confidence in Europe is up. Talk of a split into a two-tier Europe has abated. Large economies such as Spain and Italy recorded marginally positive GDP growth in the first quarter. Smaller economies are also doing relatively well, and Portugal is now described as the ‘poster child’ of economic turnaround: At the end of 2013, Portugal’s GDP was growing at an annualised rate of 1.6%, its unemployment rate was down to 15%, and its exports have picked up sharply, now representing over 40% of GDP compared with 28% in 2008.

Yet, we think these modestly positive signs are being overblown and that it is too early to relax. Of course, Portugal’s export performance is improving the balance sheet of some of its firms, but its overall GDP figures are far from impressive. The growth number cited above is based on only one quarter. Portugal’s actual annual GDP numbers for the 5 years commencing 2009 were –3%, +2%, -1%, -3%, -1%. The cumulative effect of these performances means that its economy still stands at only 93% of the size at the end of 2008. Moreover, net government debt to GDP ratio is a daunting 120%, and the private sector debt is even greater (220% of GDP).

Similar comments could be made about Greece. Two sovereign debt bailouts failed, and 2012 saw a restructuring involving debt cancellation. By the end of 2013, Greek GDP has shrunk by 25% from pre-crisis peak. Unsurprisingly, we read that this may have bottomed out. Consumer purchases are up, and surveys report that manufacturers are more confident. However, the only hard evidence of good news is that the rate at which the economy has been shrinking is slowing, and implemented austerity has now generated a primary budget surplus (i.e., a surplus before interest payments). The bad news continues to be the very high unemployment (27% of the labour force) and the huge public-debt-to-GDP ratio: a European outlier at 170%.

Yet, in early April Greece, returned to the capital markets, issuing €3 billion of 5-year debt at a cost of 4.95%. The media have proclaimed this bond issue is new evidence of economic turnaround. This is a mistake, just as it is mistaken to cite increasing bond prices as evidence of turnaround in Portugal. Under normal circumstances, being able to issue debt at such relatively low interest (compared to recent rates) would indeed suggest a credible faith in the health of the Greek economy, but at present it may in fact instead be a sign of financial markets’ belief that should Greece run into trouble again, it will be bailed out. Again. The tail cannot wag the dog.

We see scant evidence of a European economic recovery, and consider that improvements in market appetite for Portuguese and Greek debt are a different point: The ECB’s loose money policy has driven up prices of all sovereign bonds. Investors see nothing on the horizon other than continuing strong political support for the ECB from all Eurozone countries. Investors view the likelihood of any of the PIGS being “let go” as very low, and consider rescues via fiscal transfers from strong countries to be a far more likely worst-case scenario. This explains why bond yields have converged to very tight levels; with those of the weakest country (Greece) bearing the highest yield of 4.8%, only 3.3% above Germany’s 1.5% level.

The Fed claims to have reduced (“tapered”) its purchases of bonds through QE. Closer scrutiny of the types of bonds it has been buying reveals, however, that the implicit subsidy to bank lending has not been reduced.

The Fed has reduced or “tapered” (from $85bn to $65bn, soon to drop to $55 bn) its monthly purchases of bonds from banks.

However, bond exposures are never measured by reference only to such nominal face values. Exposure to the credit risk of a borrower (or, in the case of government and high quality bonds, to interest rate risk), is measured in terms of “duration” which considers maturity and the count and timing of the bond’s coupons. ’Duration’ is similar to ’average maturity’, but also incorporates the specific coupon and principal repayment schedule of a given bond or portfolio of bonds. For example, the duration of a 4% bond that pays interest every month is shorter than the duration of the same bond paying interest only at the end of each year.

Data published by the Federal Reserve Bank of St Louis shows that the face amounts of bonds purchased have indeed been reduced. However, since the Fed has substantially increased the proportion of longer-dated bonds that it buys, if one considers duration, the true quantity of support provided to banks by the Fed has not reduced. In other words, the Fed may have bought fewer bonds, but it selectively picked the more burdensome ones.

Why is this significant? By and large, banks borrow short to lend long. This means they are exposed not only to the absolute level of interest rates, but also to the term structure of rates. The Fed has the power, through debt purchases, to affect both. In short maturities, there is little difference between ’duration’ and nominal face values, so the nominal amount of debt the Fed purchases is a fair indicator of the amount of interest rate risk it takes over from the banks. The less interest rate risk, the more long-term lending the banks can make, and the greater the implied potential ’money multiplier’ they can generate.

When the Fed buys long maturities (beyond 10 years), banks see their risk profile drop, and are more inclined to lend. So the risk/reward for banks can shift dramatically when the Fed purchases 10y+ bonds instead of, say, 1y bonds, and this lower risk can easily compensate or even overcompensate for the ’taper’ currently underway. Indeed, the data show that the Fed has increased its purchases of precisely the 10y+ bonds, the ones that really take the bulk of risk off the banks.

At the end of the day, monetary policy is just as loose today as it was pre-taper, and perhaps even looser, depending on how you define and measure risk. The ’taper’ is a mirage. Bank risk and liquidity managers think in ’duration’ terms, and as long as the Fed continues to absorb more and more 10y+ bonds, the banks will continue to have an incentive to increase lending and leverage, in spite of any ’taper’.

Forward Guidance is a new wonder-kid on the block of monetary governance. Unless it can solve the ancient central banker’s problem of commitment, it can actually contribute to the re-emergence of financial bubbles.

The Bank for International Settlements’ latest quarterly review attracted attention because it questioned the effectiveness of “Forward Guidance (FG)”, a central bank’s declaration that it will only alter monetary policy when a pre-defined trigger level is reached by the relevant national economy. Noting that both the Fed and the Bank of England have pledged not even to consider raising rates until employment substantially increases, and that both the ECB and the Bank of Japan’s FG is linked to inflation targets, the BIS stated that evidence of the desirability FG was “mixed”. In brief, as long as the public perceives that the FG benchmarks are discretionary and subject to frequent revisions, FG “raise[s] the risk of an unhealthy accumulation of financial imbalances”.

The most favourable words in the Review conceded that FG can indeed have an impact on short term interest rates. This was no surprise since it is usually the short term financial assets that are the most price sensitive to any central bank policy change or indication of likely future change. The downside of FG can be the ‘financial imbalances’, a polite term for asset price bubbles affecting longer term investments. Examples of such imbalances abound. In the UK, there has been a 9% rise in house prices in the past year. Of note are the soaring premium prices in London, where today ordinary small terraced (joined) houses in unattractive outer suburbs are now trading at prices of around €1 million. Even mainstream media are talking about the economic damage that these prices are causing. If FG is contributing to this, we may be back to the pre-crisis world of bubbles and FG may not be the knight in shining armour it is often presented as.

A certain degree of confusion perhaps explains recent market volatility. The momentum behind Q1 stock market gains was the belief that loose money policies were set in for the medium term. But every now and then the markets appear to realise that loose money can only inflate asset prices for so long. Accordingly, despite the employment number hitting analysts’ expectations, stock markets in the US and Europe have conceded much of their year to date 2014 gains.